Walking in suspended animation

SUBHEAD: We need to walk calmly away from the game before the music stops in order to minimize the consequences of being wrong. Image above: In 1929 a family seeks the sunny side of life. From (http://midclassillustration.blogspot.com/2009/11/realismrockwellian.html). By Nicole Foss on 22 November 2010 for The Automatic Earth - (http://theautomaticearth.blogspot.com/2010/11/november-22-2010-waking-from-suspended.html) The counter-trend rally from March 2009 has lasted a long time, significantly longer than we initially thought it would. This is not particularly surprising, since rallies can take many complex forms and market timing is probabilistic. We were predicting a rally when most were calling for an accelerated decline. We did that because we see the world in terms of human herding behaviour, which is a vital driver of where we are collectively going. In March 2009, people were almost universally bearish, so we were looking for an upturn. A new trend takes time to disseminate and become received wisdom, starting slowly, reaching critical mass, and then shifting sharply in the new direction. By the time the new received wisdom has become so entrenched that there is almost universal agreement, there is virtually no one left to act on that opinion and carry that trend any further in the same direction. That was the case in March 2009, and it is the same now, albeit in the opposite direction. Now strongly positive sentiment indicators suggest that the rally is ending, and its end should also bring to an end the long period of extend-and-pretend in which our societies have been sleep-walking for 18 months. We have been living through a long period of suspended animation, with resurgent confidence and renewed suspension of disbelief taking the pressure off both central authorities and illiquid asset markets. The interventions of central bankers and treasuries appear to work where the prevailing psychology is supportive - where the collective is not in the mood to call their bluffs. This leads to praise for those same authorities for saving the system, on the assumption that they are in fact in control. In the case of asset markets, values have remained unclear because so few assets have been changing hands. Since there has been no sceptical probing for price discovery, it is still possible to maintain the fantasy that these so-called assets are worth what they once were. They can still be marked on the books of banks at 100 cents on the dollar, giving the banking system the illusion of health. This is partly because the big players see it as being in their best interests to stick together in order to prevent the cold light of day shining too strongly on the festering contents of their vaults. Such periods always come to an end eventually, typically when interests between the big players diverge. The Fed and the Treasury have been hoping that they can maintain the illusion long enough for confidence to return on its own, but this is not realistic with the unprecedented overhang of leverage in our global financial system. When the rally ends, that divergence of interests is likely to intensify, and it may not take long to reach breaking point. With the end of the rally, the psychology supportive of cooperative or top-down actions will end. This environment will be very unkind to both central authorities and illiquid asset markets. Plans will fall flat on their faces, bluffs will be called and price discovery (at drastically lower levels) will reprice whole asset classes at a stroke. At this point the insolvency of the banking system will be laid bare. The repricing of 'assets' such as derivative contracts on the books of banks is comparable to the repricing of a neighbourhood in a property price collapse. Initially, in either case there is a wide gap between what sellers are prepared to accept and what buyers are prepared to pay. So long as no one bridges that gap, there is no price discovery. Eventually, however, a CDS derivative contract holder with an interest in seeing something fail for profit will force it to happen, or a property seller will get get desperate enough to drastically cut his price. In each case, price discovery results. In the case of property, inventory builds up while the price gap persists. Sellers eventually try to bridge the gap to the downside, but even as they do so, what buyers are prepared to offer is also falling. Those who cut their prices too little, too late, are likely to follow the market all the way down. Whole neighbourhoods can be repriced again and again by the actions of a few sellers at the margins. Most people need do nothing for the price of their asset to fall, placing them potentially underwater on their mortgages. Underwater mortgages in turn become an albatross round the neck of the property market. Liquidity will be limited in real estate for a very long time. As we discussed in the last post, the leverage of a credit expansion creates excess claims to underlying real wealth, and that means we are all playing a giant game of musical chairs, with perhaps one chair for every hundred people. Extend and pretend is the period of time when the music is still playing and everyone is frantically dancing, even those who understand the game, as many of them are arrogant enough to think they will be able to get out at a top. This will prove not to be true for many, hence even many very wealthy people are going to be ruined, as they were in the Great Depression. To use another analogy, cashing out at a top bears some resemblance to a fire in a theatre, where everyone is trying to get out at once through a small exit. This is not going to play out slowly, although the build up can be tortuously slow. People should be thinking of the extra time they have had as a result of an extended rally as a precious gift, not as a reason for complaint. Deleveraging will come soon enough, and when it does it will be devastating. We should appreciate every day we get before it begins in earnest, as an opportunity to put our houses in order rather than to wring another ounce of profit out of a dying system by continuing to play the game. We need to walk calmly away from the game before the music stops in order to minimize the consequences of being wrong. Early is fine, but late is not. .

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